Professional Documents
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CH 7 - Due Diligence
CH 7 - Due Diligence
By : Gaurang Badheka
CRV, Sem - 4
Contents
• Meaning of Due Diligence • Areas covered in Financial
Review (DDR) DDR
• Due Diligence – What is it? • Practical Situations in DDR
• Scope of DDR • Findings and their Impact
• Who Conducts DDR • Impact of findings from other
• Situations calling for DDR Due Diligence’s
• Types of DDR • Limitations
• Introduction to Financial DDR • Risks Involved
• Types of Financial DDR • Steps to Mitigate Risks
• Process involved in Financial • Reporting
DDR
Meaning of DDR
• Dictionary Meaning of ‘Due’ is ‘Sufficient’ & ‘Diligence’ is
‘Persistent effort or work’.
• It is an investigation into the affairs of an entity prior to its
acquisition, flotation, restructuring or other similar
transaction
• Due Diligence Review is a process whereby an
individual or an organization seeks sufficient information
about a business entity to reach an informed judgment
as to its value for a specific purpose.
Due Diligence – What is it?
• The process by which information is gathered
about:
√ A target Company
√ Its Business; and
√ The Environment in which the target company
operates
• Objective:
√ To ensure that prospective investors make and
informed investment decision
Due Diligence – What is it?
• It is a business oriented analysis not an accounting
analysis
• A fact gathering exercise with focused analysis of
information
• Understanding the industry of the target
• Reasonable level of enquiry on the affairs having
material impact on the prospects of the business
• Evaluation of business model and key business
practices
DUE DILIGENCE Vs. AUDIT
• Due Diligence is far beyond the financial
analysis. Audit is concerned with the truth
and fairness of historical financial
statements only.
Legal
Mandatory Non-Mandatory
Requirement
Historical and
Focus Historical focus
futuristic focus
STATUTORY AUDIT & DUE DILIGENCE REPORT
(DDR) –A COMPARISON
✓Commercial Aspects
Emphasis True & Fair
✓Issues concerning
Term sheet
Scope of DDR
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Types of DDR
Business Due Diligence
• A review of the market for the company's product
• A background check on the founders and key management team
• Analysis of the Company's competition
• Existing Market Share
• Expansion plans
• Analysis of Comparative Profitability & reasons for deviation if
material
• Discussions with the Company's key customers
• Review of management structure
• High dependence on single customer/supplier
• High dependence on Government policies
13
Types of DDR
Legal Due Diligence
• Looks at identifying issues related to contractual obligations
which have not been fulfilled by the Company.
• Review of key contracts related to customers, suppliers,
employees and services.
• Review of agreements/filings related to patents, copyrights,
trademarks, intellectual property rights, etc
• Compliance with the Companies Act and various other
statutes applicable to the Target
• Review of Litigation for and against the Company.
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Types of DDR
Tax Due Diligence
• Identifies and quantifies areas of tax risk to the extent
possible and assesses future tax implications
• Deals not only with historical liabilities but also assesses
future tax implications and finds opportunities to minimize tax
• Tax implications of the various possible structures
• Tax DDR is a key ingredient in assessing whether to proceed
with a deal
15
Types of DDR
System (IT) Due Diligence
• Confidence that the IT assets supporting the business are up
to the task
• Review the framework for hardware and software
• Review of the Disaster Management Plan
• Coordination that all the software’s are working in sync and
there is no conflict between any of them.
• Advise on system integration with the acquirer’s information
system
16
Types of DDR
Environmental Due Diligence
Environmental due diligence is the systematic identification of the
environmental risks and liabilities associated with an organisation's
sites and operations
• Provides the acquirer with a detailed assessment of the historic, current
and potential future environmental risks associated with the target
organisation's sites and operations.
• Review the environmental setting and history of the site
• Assess the site conditions, operations and management
• Confirm legal compliance and pollution incidents from regulatory
authorities
• The internal environmental norms of the acquirer are met
• Review contractual and other associated risks
17
Types of DDR
Human Resource Due Diligence
Human resource due diligence attempts to evaluate how people are
managed between the two companies
• How do we continue to maximize the value of human resource capital?
• What is the appropriate mix of pay and benefits for the new
organization?
• What incentive programs are needed to retain essential personnel
after the acquisition is announced?
• How are employees rewarded and compensated by the Target
Company?
• How does base pay compare to the marketplace?
• Review of comparative pay scales and designations between the
acquirer and target company.
18
Introduction to Financial DDR
“Financial due diligence has the highest significance –the final
decision, for an investor, would be in the form of financial
terms and information. It is therefore imperative that the results
of all kinds of due diligence should be translated in monetary
terms.”
• Identification of hidden risks & deal breakers
• Ensuring that all liabilities, current and contingent, are considered
• Establishing price adjustments / negotiation extent of dependency
on customers and vendors
• Off balance sheet financing
• Identification of specific indemnities & warranties reqd. from target
19
Types of Financial DDR
➢ Buy Side
• Due Diligence commissioned by the acquirer
• Focused on areas of interest for potential acquirers (financial or
strategic)
• Reporting – generally issue based
• Dataroom < > exclusive
➢ Sell Side (Vendor DD)
• Independent due diligence commissioned by the vendor
• Key tool for maximising saleability of the business in a reduced
timetable through maintaining competitive tension
• To identify potential issues and take corrective measures upfront
20
Types of Financial DDR
➢ Limited
• Not equivalent to full scale due diligence
• Focus on certain key areas based on the level of comfort
desired by the Client
➢ Full Scale
• Focus on all major aspects of financial statements
• Extent of detail is more as compared to limited due diligence
21
Methodology
Preparation
Discussion of Issue of Final
of Draft
Draft Report Report
Report
Areas in Financial DDR
23
Areas in Financial DDR
24
Areas in Financial DDR
25
Areas in Financial DDR
26
Areas in Financial DDR
27
Areas in Financial DDR
28
Practical Situations
Fixed Assets
• Underused/obsolete plant & machinery
• Assets carried at much more than current market value
due to capitalization of revenue expenditure or foreign
exchange fluctuation
• Capitalization of interest in an expansion project
subsequent to stoppage of the construction work
• Litigated assets & property
• Adjustments for capitalization of assets, software
expenses, etc
29
Practical Situations
Investments
• Target co. sold subsidiaries/business & agreed to take
over and indemnify all liabilities of the same prior to the
date of transfer, which were not reflected in the target’s
books of accounts
• Investments carried at cost though realizable value is
much lower
• Investments carrying a very low rate of income/ return
30
Practical Situations
Working Capital
• Uncollected/ uncollectible receivables
• Obsolete, slow & non-moving inventories or inventories
valued above Net Realizable Value
• Adjustment for Inventories with old names/logos in the
case of hotel industry
• Group company balances under reconciliation, etc
Deferred Revenue Expenditure
• Deferred revenue expenditure included under advances
or not normally deferrable
31
Practical Situations
Taxes
• Tax liabilities under Direct & Indirect taxes
• Pending final assessment of customs duty where
provisional assessment only has been completed
• Non availability of TDS Certificates
• Adjustment for possible liability arising out of non-
submission of Forms ‘C’ & ‘F’
• Delays and non-payment of direct and indirect taxes
• Liability on account of EPCG
32
Practical Situations
Other Claims
• Environmental problems/claims, third party claims
• Huge labour claims under negotiation when the labour
wage agreement has already expired
• Non-funded gratuity/superannuation/leave salary liabilities
• Non-compliance with enactments such as the Income Tax
Act, FEMA/FERA, Customs Act, etc. that could result in
litigation & levy of penalties
• Product warranties, defects & other liability claims, product
returns & discounts, liquidated damages for late deliveries
33
Practical Situations
Off Balance Sheet Items
• Target co. may not show any show cause notices which
have not matured into demands as contingent liabilities.
These may be material & important
• Target co. may have given “Letters of Comfort” to banks
& FIs. Since these are not “guarantees”, these may not
be disclosed in its balance sheet
• Commitments including long term contracts
• Agreement to buy back shares sold at a stated price
• Future lease liabilities
34
Practical Situations
Profit & Loss Items
• Identifying seasonality in sales, dependency on
customers
• Assessing the impact of customers gained / lost on the
bottom line
• Dependency on customers/suppliers
• Revenue recognition and cut off procedures
• Items of one off / non recurring nature
• Impact of stand alone costs
35
Findings and their Impact
The DDR findings are then quantified for impact on the final
valuation
• Deal Breakers - Those issues which would impediment the
consummation of the proposed transaction
• Negotiation points - Those issues which would be necessary to
consider in the valuation of business / negotiation of bid price
• Issues for Agreements - Those issues which would warrant
indemnities and identify conditions precedent for happening of
the transaction
• Commercial Override - Those risks and issues which are
knowingly taken over as a calculated commercial
decision
36
Impact of Findings from other Due
Diligences
The DDR findings from other due diligences mentioned before
also need to be quantified for impact on the final valuation
•Business Due Diligence – Impact of dependence on single
customer/supplier, government policies, etc. Impact of expansion
plans on future profitability of the company
•Legal Due Diligence – Any further liabilities/penalties arising out of
non compliance/defaults with regards to Corporate laws like FEMA,
Companies Act, SEBI Norms (for listed companies), etc.
•Tax Due Diligence – Penalties for non-payment, delays in
payment of statutory liabilities. Liabilities arising on settlement of
assessments.
37
Impact of Findings from other Due
Diligences
• System Due Diligence – Costs involved in case migration of
data. Issues related to strengthening of the information system.
Issues with regards to all necessary safeguards being in place
when an emergency occurs
• Environmental Due Diligence – Penalties/liabilities with regards
to non-compliance of environmental guidelines issued by the
respective authorities. Costs involved with
aligning/synchronization the environmental guidelines of the
acquirer
• Human Resources Due Diligence – Costs involved with
aligning the pay scales of acquirer and target. In case there is
excess staff on the roles of the target then severance costs to be
looked into.
38
Undertakings from Management
Undertakings should normally cover the following:
• Titles & ownership
• Various Government consents / licenses
• Correctness of all information supplied
• Product / service warranties, damages & other claims
• Contingent liabilities
• Recoverability of all current assets
• Registration of Intellectual properties
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Limitations
For Service Providers
• Limited scope of review fixed by the client /acquirer Titles
& ownership
• “Too much to see in too little time”
For Acquirers/Investors
• Inability to determine the scope
• Inability to ensure proper co-ordination between service
providers
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Risks Involved
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Risks Involved
For Acquirer/Investor
• The investor may pay higher than
the fair price for acquisition
• The investment performance may
not be upto the expectation or may
perform badly
• A bad strategic investment may
result in losing a considerable
market share or reputation
42
Steps to Mitigate Risks
By Service Provider
• Clearly understand the objectives
& the complexities of the
assignment based on which the
scope should be finalized
• The DDR report should disclose
all the limitations of the
assignment
• A proper engagement review
should be carried out before
accepting the assignment and
deciding the scope
43
Steps to Mitigate Risks
By Service Provider
• Schedule meetings with other
reviewers
• Collect from the client reports of
all other due diligences
• The due diligence team should
consist of at least one person
who is familiar with the industry,
the target is involved in
44
Steps to Mitigate Risks
By Acquirer/Investor
• Should ensure that the scope is
comprehensive
• Proper coordination amongst all
service providers should be
encouraged
• An integrated service provider
may be hired
• To ensure that the target
provides all necessary
information
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Reporting Aspects
Identifying Issues
• Identified issues to be discussed with Mgmt & other
advisors
Replies from Management
• Resolve issues identified
Preparation of Draft Report
• Draft report submitted
Discussion on the Draft Report
Issue of Final Report
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